BRINGING BACK THE MICE May be the Common Sense Solution for the Economy, But It Presents New Issues for the Equity Market

We are pleased with the market’s recent strength and believe it should continue, given the economic recovery just getting underway. At the same time, we want to avoid being complacent and be on guard for emerging concerns. As we look ahead, perhaps the largest threat to the market’s performance later in 2021 is not valuation or anemic, COVID-plagued growth, but rather that our current reflation solution works too well. Massive stimulus spending, record low interest rates, and a weakening dollar should lead, as intended, to economic recovery, and the strong equity market is currently anticipating that. But when the recovery is in full force, there is a risk that a well-stimulated, vaccinated economy will run too hot. While we are not convinced this will happen, we remain on the lookout for early warning signs of an overheating economy, and wanted to discuss the consequences of this non-consensus viewpoint.

Rational Solutions Can Cause New Problems There is a story I read to our daughters when they were young about a kingdom that was overrun by mice. After

| MARKET COMMENTARY | 02 . 26 2021 | MARKET COMMENTARY talking with his advisors, the king’s solution was to buy many cats. That, of course, led to its own problems, so a pack of dogs was brought in, and then lions to get rid of the dogs and finally elephants. When herds of elephants threatened the kingdom, the only solution (you guessed it) was to bring back the mice to scare the elephants away. Each step was rational and cured the current problem; each caused a new set of challenges.

This story captures the essence of modern economic policy. You need only be old enough (or well-read enough) to appreciate that there are no new solutions: only cats to fight the mice and dogs to fight the cats, all MAI CAPITAL the way around until the mice are welcomed back again. This time, the mice we are welcoming back go by the name of “reflation.” Just like the other animals in the tale, introducing this reasonable solution could bring its own set of issues. And those issues need to be understood, because they may eventually be enough to stop the stock market’s current rise.

For the first time in history, in 2020 we purposely stopped our economy to fight the COVID epidemic. We did it effectively – the collapse of manufacturing, dining, entertainment, and travel was unprecedented. So now we are on a rational and necessary quest to “reflate.” The consensus view remains that we have done enough to cause (good) “reflation,” but not so much that we cause (bad) “.” The former is reinvigorating. The latter would cause interest rates to rise “too high” (whatever the market determines that means) or produce other ill effects. The proof that the market believes we are accomplishing this just-enough-but-not-too-much reflation is simply that stocks continue to rise in the face of unprecedented reflationary steps. The market is, at the moment, predicting a “soft landing.”

Wolf, or No Wolf? The soft landing camp has the weight of recent history on its side. Stimulus after the 2008 global financial crisis, as well as monetary interventions throughout the last decade, raised fears of inflation, but it never materialized. Today, the “Soft Landers” point to slack and productivity from technology as deflationary forces that will offset the inflationary impact of recent stimulus and low interest rates. Such factors have indeed prevented inflation from taking hold since 2008. Today, economists and market pundits who warn of inflation and higher rates are looked at like the boy who cried wolf. MAI CAPITAL | MARKET COMMENTARYGENERAL | 02 RESOURCE . 26 . 2021 reason for themarket to turndownward, itdoesmake itmore vulnerable to bad news. times expected 2021earnings, about30%higherthanthe30-year average. Whilehighvaluation aloneisn’t a highest onrecord. level Even ifyoulookahead to higherpost-COVID earnings, themarket issellingat 22 times earnings, slightlybelowits 100-year average. Now, it isat 30times,far aboveits average andthethird wellmaybethecase, butitmayalsobewiseto digalittleThat very deeper. In2013,themarket was at 15 Shouldn’t that giveusconfidence that higher rates in2021won’t hurtthe stock market thistime? Tantrum” drove interest rates higher, but the strong economy allowedstocks to surge ahead byyear-end. Still, thestock market, after aturbulentsummer, enjoyeda terrific so-calledyear in2013. The “Taper on thechin. early Maythat year untilAugust, the10-year yielddoubledfrom 1.5%to 3.0%.Fixed income securitiestook it rates low. Inthree days(June 19-21),theyield onthe10-year bondrose almost 40basis points. Andfrom reduce –thevolumeofbondpurchases itwas thenundertaking to addliquidityto themarket andkeep Chairman BenBernanke announced that theFed at somefuture date wouldreduce butmerely –not halt, and there willbeatimeinthefuture whenitwillnolonger beneeded.For example, inJune2013,thenFed pressure simplywheninvestors start to thereflation thinktheFederal believes agenda hasworked Reserve We are not anticipating amarket crash orabout of1970sstyle inflation. Butthe market may come under is arealistic chance of thishappening butthemarket islargely ignoringsuchapossibility. the answer isunknowable at thispoint. Theimportant thingfor investors to appreciate isthat there consequences of thisso-far-successful reflation go too far andeventually upset themarket? Ibelieve So far, allofthisisgood. It’s asignoflife inaneconomy that was ondeath’s door. Thequestion is: Treasury –hassteepened to its highest in4years, level typically seenassignofastrengthening economy. –thedifferencein sixmonths).Inaddition,theyieldcurve between theyieldon2-year andthe10-year has risenfrom 0.51%inAugust to over1.3%today (not highbyhistorical standards, butmore thandoubling rise ofbitcoin.) Inaddition,interest rates are already movinghigher. Theyieldonthe10-year U.S. Treasury real estate prices are allhigherbydoubledigits from ayear ago. (Andthat’s not to mentionthemeteoric evidence wouldincludethingsweare starting to see:Commodityprices are beginning to rise.Oil,gold, and And whentheprofessor asked youwhat early plan proofwas working,your youhavethat yourinflationary that supportaweaker currency. checkandcheck. Check, ($5trillionofdeficitpushinterestmoney stimulus spending); rates aslowpossible;andadopt policies economy,inflation inadeveloped yourchecklist wouldincludeallthethingswe’ve already done:print If youwere inanEconomics 101class,andtheprofessor asked youto write anessayabouthowto cause to stimulatepolicy-by-neglect that serves U.S. exports. Trump andnowBiden,hasstood byasthevalue ofthedollarhasfallen 10%since last March, anoften used range. Inresponse, housingprices inmanylocations havejumped.Finally, theU.S. underboth government, for longer.” Insodoing,ithaspushedmortgage rates to record lows,with30-year fixed rates inthelow-2% addition, theFederal haspulledoutallthestops Reserve andisonrecord assayingrates willstay “lower trillion instimulus timesasmuchfiscal spending,aboutseven In stimulus asinthe2008financialcrisis. an infrastructure billexpected to beover$1trillionwilllikely pass thissummer. That amounts to about$5 It isexpected that theBidenadministration willpass anadditional$1.5trillionwithinweeks.Inaddition, was about$790billion.Thestimulus passed so far bytheformer Trump administration was $2.4trillion. past decade ofeasy money. Thefiscal stimulus passed byCongress in2009 to fighttheglobal financialcrisis be rightagain, butthere isvalue infocusing onthedifference between what ishappening today versusthe It’s worthremembering, showup. though,that TheSoftLandersmay dideventually thewolfinstory Will the Will the MAI CAPITAL | MARKET COMMENTARYGENERAL | 02 RESOURCE . 26 . 2021 energy, andcommunications companies can continue to grow, grow faster. and mayeven also thriveinahigherinterest rate Technology, environment. financials(so longasthere isnot a ), might exceed its usefulness.There are somesectors are that good webelieve nowandshould aswemanageHaving saidthat, yourinvestment portfolio, weare mindfulofthepossibility areflation that remember that inthelong-term, sharpprice movements often create opportunities for patient investors. inflation environments overthe past Ifhigherinflation andinterestcentury. rates do causemarket volatility, market environments to change, and the U.S. stock market hasexperienced awiderange ofinterest rate and thebest isnotWe believe policy to panic andstick to yourlong-term plan. Itisnormalfor economic and So, what isanequityinvestor to doasthekingbringsback themice? Conclusions to life, usuallycaused byinterest rates rising. is that there are plentyofhistorical periodsinwhichthestock market fades astheeconomy even comes back compensate for thecompression inP/E multiplesthat wemayexperience asrates rise.Onethingwedoknow unsettling themarket. Wealsodon’t knowwhether earnings growth at that timewillbesostrong that itwill probably that weare months orquarters afew (butnot years) away from theprospects ofsuchanevent What wedon’t maynot knowiswhen.Suchanevent happenfor years, butamore realistic timeframe is Finally, weknowthemarket willbeanxiousto anticipate suchashift. the Federal willstop Reserve buyingenormousamounts offixed income securities to keep interest rates low. rates As environment. rise,valuations maynot looksobenign.Wealsoknowthere willcome a timewhen know themarket iscurrently sellingat valuations lowinterest are that reasonable webelieve inavery rate It’s important to distinguish what wecan knowwithsomedegree ofconfidence from what we can’t. We Market P/E well above Historical Average source: Bloomberg On the other hand, companies whose share prices rely solely on high but slow-growth dividends, like utilities, may come under pressure as higher overall rates make their securities less attractive. With a lower dollar, international companies may be more attractive, as their local profits will translate into more U.S. dollars. Finally, the same strong post-COVID growth that may push up interest rates could also make formerly mediocre emerging markets worth a look.

Our purpose with this piece is to be forward-thinking, not alarmist. There are plenty of opportunities in a world of higher interest rates and moderate inflation — if that world even emerges at all — and we look forward to taking that journey with you. GENERAL RESOURCE | MARKET COMMENTARY | 02 . 26 2021 | MARKET COMMENTARY MAI CAPITAL

Author: Chris Grisanti, JD, CFA, Chief Equity Strategist & Senior Portfolio Manager, MAI Capital Management Information updated as of 02.26.21

This review has been prepared by MAI for informational purposes only. This is not a recommendation to buy or sell any security. Past performance is not a guarantee of future results. Statements contained herein are speculative and not a guarantee of future events. Forward- looking statements are based on the author’s current views and assumptions and involve known and unknown risks and uncertainties that could cause actual results, performance or events to differ materially from those expressed or implied in such statements. Opinions expressed herein reflect the author’s judgment and are subject to change based on economic, market and other conditions. It should not be assumed that this is a forecast of future events or that any security transactions, holdings, or sector discussed were or will be profitable, or that the recommendations or decisions we make in the future will be profitable or will equal any investment performance discussed herein.

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